IRS denies section 501(c)(3) exemption to a mentoring organization tied to a related LLC

Plain-English summary

The IRS issued a final adverse determination denying tax exemption under IRC § 501(c)(3) to a nonstock corporation formed to mentor underachieving students and provide related support services. The IRS said the application did not describe the proposed activities in enough detail and contained contradictions about staffing, services, finances, and the organization's relationship with a related LLC. It also found that the organization had not shown that it served a large and indefinite charitable class, and that its operations appeared functionally inseparable from the LLC and could provide a substantial private benefit. The final letter stated that donors could not deduct contributions under IRC § 170, and the organization was required to file federal income tax returns within 30 days unless it requested an extension.

Ruling snapshot

• Question: Did the organization qualify for exemption under IRC § 501(c)(3) based on its proposed charitable activities and its relationship with a related LLC?
• Outcome: Denied
• Key authorities: IRC §§ 501(a), 501(c)(3), 170, 6110, and 7428; Treas. Reg. §§ 1.501(a)-1(c), 1.501(c)(3)-1(a), (c), and (d); Rev. Proc. 2012-9, § 4.03

Full text (IRS public release)

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Number: 201242015 Contact Person:
Release Date: 10/19/2012

Identification Number:
Date: July 27, 2012

Contact Number:

Employer Identification Number:
Form Required To Be Filed:

Tax Years:
UIL: 501.00-00; 501.32-00; 501.33-00

Dear

This is our final determination that you do not qualify for exemption from Federal income tax as
an organization described in Internal Revenue Code section 501(c)(3). Recently, we sent you a
letter in response to your application that proposed an adverse determination. The letter
explained the facts, law and rationale, and gave you 30 days to file a protest. Since we did not
receive a protest within the requisite 30 days, the proposed adverse determination is now final.

Because you do not qualify for exemption as an organization described in Code section
501(c)(3), donors may not deduct contributions to you under Code section 170. You must file
Federal income tax returns on the form and for the years listed above within 30 days of this
letter, unless you request an extension of time to file. File the returns in accordance with their
instructions, and do not send them to this office. Failure to file the returns timely may result in a
penalty.

We will make this letter and our proposed adverse determination letter available for public
inspection under Code section 6110, after deleting certain identifying information. Please read
the enclosed Notice 437, Notice of Intention to Disclose, and review the two attached letters that
show our proposed deletions. If you disagree with our proposed deletions, follow the
instructions in Notice 437. If you agree with our deletions, you do not need to take any further
action.

If you have any questions about this letter, please contact the person whose name and
telephone number are shown in the heading of this letter. If you have any questions about your
Federal income tax status and responsibilities, please contact IRS Customer Service at

1-800-829-1040 or the IRS Customer Service number for businesses, 1-800-829-4933.
IRS Customer Service number for people with hearing impairments is 1-800-829-4059.

Sincerely,

Lois G. Lerner
Director, Exempt Organizations

Enclosure
Notice 437
Redacted Proposed Adverse Determination Letter
Redacted Final Adverse Determination Letter

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

TAX EXEMPT AND
GOVERNMENT ENTITIES

DIVISION
Date: June 6, 2012 Contact Person:
501.00-00 Identification Number:
501.32-00
501.33-00 Contact Number:
FAX Number:
Employer Identification Number:
Legend:
LLC =
B =
C =
D =
E =
x =
Letter 1 =
Letter 2 =
Letter 3 =

Dear

We have considered your application for recognition of exemption from Federal income tax
under Internal Revenue Code section 501(a). Based on the information provided, we have
concluded that you do not qualify for exemption under Code section 501(c)(3). The basis for
our conclusion is set forth below.

FACTS

You are organized as a nonstock corporation under state law. Your articles of incorporation
provide that you were formed for the purpose of “mentor[ing] underachieving students with
social, emotional, and behavioral problems.” Your bylaws provide that you are organized
exclusively for charitable and educational purposes and, specifically, “to provide support
services to underachieving students, children, and adolescents with social, emotional, and
behavioral problems/disorders, and individuals with mental illnesses.”

You were formed by LLC. The language you use in your application to describe your goals,
objectives, staff, and services is identical to the language used to describe the goals, objectives,
staff, and services of LLC on its website, x, a copy of which is enclosed.

In your application you state that your goal is “to provide the support necessary to empower
individuals to enhance their overall functioning and define and actively pursue their life goals in
a healthy and productive way.” You identify three activities — therapeutic mentoring, tutoring,
and group therapy — and state that therapeutic mentoring and group therapy are services
provided at LLC.

Your initial board of directors comprises six directors, including B, C, D, and E. B and C are
business partners in LLC. D is the father of B, and E is the mother of C. According to your
application, your directors “are all certified, licensed, degreed, and experienced individuals hired
on a part-time/contractual basis.” Further, your “multi-disciplinary professional staff includes
clinical social workers, psychologists, teachers and counselors who have a wide range of
specialized skills and expertise.” You share office space with LLC. Accompanying your
application was a copy of a form titled “Referral for PRP Services” that appears to be used by
LLC. You also said that you will solicit grants from foundations and donations from individuals.

In Letter 1, you said that you will not charge fees for your services. In response to our question
whether you refer individuals to LLC or whether LLC refers cases to you, you told us that LLC is
a therapeutic community support program. You said that the clients of LLC are required by
state law to be actively participating in therapy and have active insurance. If LLC receives a
referral, but the referred youth is not actively enrolled in therapy or does not have insurance,
you would like to take the case and provide as much service as possible. You said that you are
“designed to provide mentoring and support services to at risk youth ... on a volunteer basis.”
You also said that you would not compensate your board members and that you will not pay
rent to LLC for space or equipment.

In Letter 2, in response to our question whether you take into consideration a person’s individual
or family income in determining whether to provide services to that person, you told us that
“individual income level is not a consideration when applying for service. Clients are assessed
based on the need for services.”

In Letter 3, you told us that it was your intent—

... to seek sponsorship thru the development of positive events and programs that promote
a safe and fun environment for kids. From local businesses and networking we will have
monthly events/programs that bring awareness to the need for positive mentoring
relationships.... We have already secured partnerships with area churches, schools, and
businesses to use as event sites. Further, we have created an interest in mentoring
services that are greatly needed in the urban community.

You told us that “all funding raised will be used to reimburse mentors for travel and time, and to
maintain a certain level of professional services that are tracked and monitored.” Finally, you .
said that you do not plan to lease separate office space.

As part of the Form 1023 application, you are asked to provide financial information in the form
of a “statement of revenue and expenses” (“statement”). The statement you provided with your
application showed revenue solely from “gifts, grants, and contributions.” For each year

reported, you also showed expenses in an amount equal to the amount of revenue reported,
though you did not itemize your expenses. In Letter 1, you provided a revised statement.
Again, you reported revenue solely from “gifts, grants, and contributions.” For each year
reported, you again reported expenses equal in amount to the amount or revenue reported.
Expenses were categorized as “Occupancy.” You told us that “the revenue figure represents
the in-kind donations from LLC for office space, supplies, equipment, and utilities.” In Letter 2,
you provided another statement covering the same years reported in the statement submitted
with your application, but this revised statement indicated no revenue or expenses for any of the
years reported. In Letter 3, you provided a three year projected budget showing income from
“grants, donations, events” and expenses itemized in a variety of categories, the largest
amounts being attributable to “mentors/counselors,” “community integration/events,” and
“marketing.”

LAW

Section 501(a) of the Code exempts from Federal income taxation organizations described in
section 501(c).

Section 501(c)(3) of the Code describes organizations organized and operated exclusively for
charitable, religious, educational, or other specified exempt purposes, no part of the net
earnings of which inures to the benefit of any private shareholder or individual.

Section 1.501(a)-1(c) of the Income Tax Regulations (“regulations”) states that the words
“private shareholder or individual” in § 501 refer to persons having a personal and private
interest in the activities of the organization.

Section 1.501(c)(3)-1(a)(1) of the regulations states that, in order to qualify under § 501(c)(3) of
the Code, an organization must be both organized and operated exclusively for one or more
exempt purposes. If an organization fails to meet either the organizational or operational test, it
is not exempt.

Section 1.501(c)(3)-1(c)(1) of the regulations states that an organization will be regarded as
"operated exclusively" for one or more exempt purposes only if it engages primarily in activities
which accomplish one or more of such exempt purposes specified in § 501(c)(3) of the Code.
An organization will not be so regarded if more than an insubstantial part of its activities is not in
furtherance of an exempt purpose.

Section 1.501(c)(3)-1(c)(2) of the regulations provides that an organization is not operated
exclusively for one or more exempt purposes if its net earnings inure in whole or in part to the
benefit of private shareholders or individuals.

Section 1.501(c)(3)-1(d)(1)(ii) of the regulations provides that an organization is not organized or
operated exclusively for one or more purposes specified in § 501(c)(3) unless it serves a public
rather than a private interest. Thus, to meet the requirements of § 501(c)(3), it is necessary for
an organization to establish that it is not organized and operated for the benefit of private

interests, such as designated individuals, the creator or his family, shareholders of the
organization, or persons controlled, directly or indirectly, by such private interests.

Section 1.501(c)(3)-1(d)(2) of the regulations provides that the term “charitable” is used in
§ 501(c)(3) in its generally accepted legal sense. Such term includes relief of the poor and
distressed.

P.L.L. Scholarship Fund v. Commissioner, 82 T.C. 196 (1984), held that an organization that
raised money for college scholarships from the operation of bingo games on the premises of a
lounge was not exempt under § 501(c)(3). Three of the organization's five board members were
the two owners and an accountant/director of the lounge. The court stated that more than an
insubstantial purpose of the taxpayer’s activities was to attract persons, by way of the bingo
games, onto the premises of the lounge expecting that they would purchase food and
beverages while participating in the games. In fact, the court continued, the taxpayer’s activities
were, in substantial part, designed to enhance the profitability of the lounge. To ensure this
result, the articles of incorporation of the taxpayer named three of its five directors as owners or
directors of the lounge, with subsequent directors to be appointed by the board of the lounge.
Therefore, the board was and always would be controlled by the directors of the lounge.
Consequently, all of petitioner's fundraising activities could be controlled by the owners of the
lounge to provide them with maximum benefit. Even though the taxpayer and the lounge kept
separate accounts and no cash payments were made from the taxpayer to the lounge for rent or
wages, the activities of the two were so interrelated as to be functionally inseparable.

In KJ’s Fund Raisers, Inc. v. Comm’r, T.C. Memo 1997-424, the petitioner was organized to
raise funds for distribution to charitable causes. Petitioner's business was to sell lottery tickets
on the premises of KJ’s Place, a lounge owned by Kristine Hurd and James Gould. Hurd and
Gould were both officers and directors of petitioner. The Tax Court found that the manner in
which petitioner is operated benefits private interests —- KJ’s Place and its owners. Petitioner's
lottery tickets are sold at a single location, KJ’s Place, during the regular business hours of KJ’s
Place, and are overseen by the owners of KJ’s Place. The court said that petitioner's practices
strongly suggest that Hurd and Gould are free to set policy for their own benefit without
objection from petitioner's board, and that KJ’s Place had benefitted from the publicity
surrounding donations given by petitioner. Although the petitioner was engaged in the exempt
activity of raising money for charitable purposes, the court concluded that it was also operated
for the substantial private benefit of KJ’s Place and its owners. Therefore, petitioner was
disqualified from exemption under § 501(c)(3).

Section 4.03 of Rev. Proc. 2012-9, 2012-2 I.R.B. 261, provides that exempt status may be
recognized in advance of operations if proposed activities are described in sufficient detail to
permit a conclusion that the organization will clearly meet the particular requirements of the
section under which exemption is claimed. A mere restatement of purposes or a statement that
proposed activities will be in furtherance of such purposes will not satisfy this requirement. The
organization must fully describe all of the activities in which it expects to engage, including the
standards, criteria, procedures or other means adopted or planned for carrying out the activities,
the anticipated sources of receipts, and the nature of contemplated expenditures. Where the
organization cannot demonstrate to the satisfaction of the Service that its proposed activities will

be exempt, a record of actual operations may be required before a ruling or determination letter
will be issued.

For an organization claiming the benefits of section 501(c)(3), “tax exemptions are matters of
legislative grace and taxpayers have the burden of establishing their entitlement to exemptions.’
Christian Echoes Nat’l Ministry, Inc. v. United States, 470 F.2d 849, 854 (10th Cir. 1972), cert.
denied, 414 U.S. 864 (1973). The applicant for tax exempt status under section 501(c)(3) has
the burden of showing it “comes squarely within the terms of the law conferring the benefit
sought.” Nelson v. Comm’r, 30 T.C. 1151, 1154 (1958).

The Tax Court has stated that an application for tax-exempt status “calls for open and candid
disclosure of all facts bearing upon [an Applicant's] organization, operations, and finances to
assure [that there is not] abuse of the revenue laws. If such disclosure is not made, the logical
inference is that the facts, if disclosed, would show that the [Applicant] fails to meet the
requirements of section 501(c)(3).” Bubbling Well Church of Universal Love, Inc. v. Comm’r, 74
T.C. 531 (1980). See also, Founding Church of Scientology v. United States, 188 Ct. Cl. 490,
498, 412 F.2d 1197, 1201 (1969), cert. denied, 397 U.S. 1009 (1970). Furthermore, the courts
have repeatedly upheld the Service's determination that an organization has failed to establish
exemption where the organization fails to provide requested information. “[Applicant] has, for
the most part, provided only generalizations in response to repeated requests by [the Service]
for more detail on prospective activities....Such generalizations do not satisfy us that [applicant]
qualifies for the exemption.” Peoples Prize v. Comm’r, T.C. Memo 2004-12 (2004).

ANALYSIS
Failure to Establish Qualification for Exemption

You have asked us to recognize you as an organization described in § 501(c)(3) of the Code.
But before we can conclude that you are organized and operated exclusively for one or more
exempt purposes described in § 501(c)(3), we must have a clear and unambiguous
understanding of your activities. Under the criteria set forth in section 4.03 of Rev. Proc. 2012-
9, we will recognize your exempt status only if your operations are described in sufficient detail
to permit a conclusion that you will meet the requirements of § 501(c)(3). We find that your
application does not meet those criteria. You provide only generalized statements of your goals
and objectives. While you outline three activities — therapeutic mentoring, tutoring, and group
therapy — you do not provide any explanation of how these activities relate to your goals, nor do
you provide a full description of the standards, criteria, procedures, and methods to be used in
carrying out such services.

Furthermore, your application is rife with seeming contradictions. For example, in your
application you state that your directors are “all certified, licensed, degreed, and experienced,”
and are “hired on a part-time/contractual basis,” but you neither describe the terms of their
contracts nor provide copies of written agreements. You also allude to an “interdisciplinary
professional staff” of “clinical social workers psychologists, teachers, and counselors.” This is
the same language used to describe the “staff experience” of LLC’s staff on its website, x.

Thus, we are left to infer that your staff is identical to LLC’s staff. Your application makes it
appear that your directors, or perhaps the staff of LLC (it isn’t clear), will be “hired on a part-
time/contractual basis” to conduct your activities. But in Letter 1, you say that services will be
provided on a volunteer basis by “individuals willing to provide the service,” though you do not
explain who those individuals might be. Again, in Letter 1, you say that no salaries will be paid
to employees, yet, in Letter 3, you list expenses for “mentors/counselors.” Your application
material included a copy of “PRP referral” form, but the form is addressed to LLC, and you did
not list PRP as one of your services. You provided several statements of revenue and
expenses, each of which seems to contradict the other. You say that you will solicit grants from
foundations and contributions from individuals, but you also tell us that the amounts categorized
as gifts, grants, and contributions on your various statements of revenue and expenses
represent “in kind donations from LLC of office space, supplies, equipment, and utilities.”

Because you have not described your activities clearly and unambiguously, we are unable to
conclude that you meet the requirements of § 501(c)(3). Specifically, you have not sufficiently
differentiated yourself from LLC to allow us to conclude that you engage primarily in activities
that accomplish exempt purposes and are not operated for the benefit of the private interests of
the owners of LLC. While, on the one hand, you have not established that your activities further
an exempt purpose, it appears, on the other hand, that a more than insubstantial purpose of
your activities is to promote the business of LLC.

To be exempt under § 501(c)(3), you must be organized and operated exclusively for charitable
purposes. Reg. § 1.501(c)(3)-1(a). You will be regarded as “operated exclusively” for one or
more exempt purposes only if you engage primarily in activities which accomplish one or more
of the exempt purposes specified in § 501(c)(3). The operational test focuses on the actual
purposes an organization advances by means of its activities, rather than on the organization's
statement of purpose or the nature of its activities. See American Campaign Academy v.
Comm’r, 92 T.C. 1053, 1064 (1989). A single activity might be directed at multiple purposes,
both exempt and nonexempt. If the nonexempt purpose is substantial in nature, the
organization will not satisfy the operational test. See K.J.’s Fund Raisers, Inc. v. Comm’r, 166
F.3d 1200, (2d Cir. 1998). The burden of proof is on the applicant to demonstrate that it is
operated exclusively for exempt purposes and that it does not benefit private interests more
than incidentally. See Church of Scientology v. Comm’r, 823, F.2d 1310, 1317 (9th Cir. 1987).

Lack of an Exempt Purpose

Section 501(c)(3) specifies various qualifying exempt purposes, including “charitable” purposes.
The term “charitable” is used in its generally accepted legal sense. Section 1.501(c)(3)-1(d)(2).
The promotion of health for the benefit of the community is a charitable purpose. See Sound
Health Ass'n v. Comm’r, 71 T.C. 158, 177-181 (1978); see also 2 Restatement, Trusts 2d,, §§
368, 372 (1959); 4A Scott & Fratcher, Law of Trusts, §§ 368, 372 (4th ed. 1989). To benefit the
community, a charity must serve a sufficiently large and indefinite class. As a corollary to this
rule, private interests must not benefit to any substantial degree. See Sound Health Ass’n v.
Comm’r at 181. It does not appear that you benefit a large and indefinite charitable class.
Rather, it appears that you benefit primarily persons referred to LLC. You told us that you would
like to take cases referred to LLC that LLC is unable to serve because the client does not

require active therapy or does not have insurance. Beyond that, it does not appear that you
have established any criteria for selecting clients. Since it does not appear that you serve a
charitable class of persons, your activities cannot be considered “charitable” within the meaning
of § 1.501(c)(3)-1(d)(2) and, therefore, you are not “operated exclusively” for one or more
exempt purposes within the meaning of § 1.501(c)(3)-1(c).

Presence of a Substantial Non-Exempt Purpose

When an organization operates for the benefit of private interests such as designated
individuals, the creator or his family, shareholders of the corporation, or persons controlled,
directly or indirectly, by such private interests, the organization does not operate exclusively for
exempt purposes. Prohibited private benefits may include an “advantage, profit, fruit, privilege,
gain, or interest. American Campaign Academy v. Comm'r, 92 T.C. 1053, 1065-66 (1989).
Should you benefit private interests, you will be deemed to further a nonexempt purpose under
§ 1.501(c)(3)-1(d)(1)(ii).

You were formed by LLC. Two of your founding directors are business partners in LLC, and
another two founding directors are related to the business partners. You share office space with
LLC. You use the same referral forms as LLC. The language you use in your application to
describe your goals, objectives, staff, and services is identical to the language used to describe
the goals, objectives, staff, and services of LLC on its website, x. Since you appear to be so
interrelated as to be functionally inseparable from LLC, we can only conclude that your activities
could be used to the advantage of LLC. See, e.g., P.L.L. Scholarship Fund v. Comm’r, 82 T.C.
at 200.

Although you state that you do not compensate your board members and do not pay rent to
LLC, it does appear that your activities provide both monetary and non-monetary benefits to
LLC. First, you state that amounts denominated as “gifts, grants, and contributions” on your
statement of revenues and expenses “refer to in-kind donations from LLC.” We are left with the
impression that LLC claims a charitable contribution deduction for the purported value of the
office space, supplies, equipment, and utilities it provides to you. Further, you anticipate
incurring expenses for “mentors/counselors.” Since you do not explain to whom the terms
“mentors” and “counselors” refer, but do imply that services are to be provided by the staff of
LLC, we are left with the impression that you will funnel any amounts you receive as gifts,
grants, and contributions to LLC as payment for services provided by its staff.

Furthermore, we assume that your activities will provide an “advantage, profit, fruit, privilege,
gain, or interest” to the owners of LLC in much the same way as the organizations described in
P.L.L. Scholarship Fund v. Comm’r and KJ’s Fund Raisers v. Comm’r were used to increase the

profitability of related for-profit enterprises. As in those cases, your founders are the owners of
a for-profit business. As in those cases, your activities are conducted by the staff and on the
premises of that for-profit business. And as in those cases, your activities appear designed to
increase the profitability of your founder’s for-profit business. When we asked you whether you
would refer cases to LLC, you did not answer the question we posed, but, instead, stated that
you would like to take certain cases referred to LLC. Thus, we infer that cases will be referred
between you and LLC. Further, you will seek sponsorships and partnerships with churches,

schools, and businesses to stage community events and programs for the purpose of raising
awareness of, and creating interest in, the services you offer. Insofar as such services are the
same services offered by LLC, are rendered by the staff of LLC, and are conducted in the
offices of LLC, it is inevitable that your efforts to promote these services will benefit LLC and its
owners.

Because we are unable to conclude either that you are operated exclusively for an exempt
purpose or that you are not operated for the benefit of private interests, we find that you do not
qualify as an organization described in § 501(c)(3).

You have the right to file a protest if you believe this determination is incorrect. To protest, you
must submit a statement of your views and fully explain your reasoning. You must submit the
statement, signed by one of your officers, within 30 days from the date of this letter. We will
consider your statement and decide if the information affects our determination.

Your protest statement should be accompanied by the following declaration:

Under penalties of perjury, I declare that I have examined this protest statement, including
accompanying documents, and, to the best of my knowledge and belief, the statement
contains all the relevant facts, and such facts are true, correct, and complete.

You also have a right to request a conference to discuss your protest. This request should be
made when you file your protest statement. An attorney, certified public accountant, or an
individual enrolled to practice before the Internal Revenue Service may represent you. If you
want representation during the conference procedures, you must file a proper power of attorney,
Form 2848, Power of Attorney and Declaration of Representative, if you have not already done
so. For more information about representation, see Publication 947, Practice before the IRS
and Power of Attorney. All forms and publications mentioned in this letter can be found at
www.irs.gov, Forms and Publications.

If you do not file a protest within 30 days, you will not be able to file a suit for declaratory
judgment in court because the Internal Revenue Service (IRS) will consider the failure to protest
as a failure to exhaust available administrative remedies. Code section 7428(b)(2) provides, in
part, that a declaratory judgment or decree shall not be issued in any proceeding unless the Tax
Court, the United States Court of Federal Claims, or the District Court of the United States for
the District of Columbia determines that the organization involved has exhausted all of the
administrative remedies available to it within the IRS.

If you do not intend to protest this determination, you do not need to take any further action. If
we do not hear from you within 30 days, we will issue a final adverse determination letter. That
letter will provide information about filing tax returns and other matters.

Please send your protest statement, Form 2848 and any supporting documents to this address:

Internal Revenue Service
ATTN:

TE/GE

NCA:

1111 Constitution Ave, N.W.
Washington, DC 20224

You may also fax your statement using the fax number shown in the heading of this letter. If
you fax your statement, please call the person identified in the heading of this letter to confirm
that he or she received your fax.

If you have any questions, please contact the person whose name and telephone number are
shown in the heading of this letter.

Sincerely,

Lois G. Lerner
Director, Exempt Organizations

Enclosure
Copy of LLC Website